Insights on the Global Financials

In this three part series, we discuss macro risk posed to the markets by the enormous Chinese banking sector. In Part #1, we take the perspective of the ‘bears’, discussing why the sector could be the epicentre of a further global sell-off and/or additional macro uncertainty. In Part #2, we take the perspective of the ‘bulls’, providing reasons why many believe the macro risk posed by the Chinese banking sector is overstated (see next post). In Part #3, we review the financial results.

Please see “Notes to Reader” at the bottom of this Insight for additional information

For BEARS, Four Reasons Why Chinese Banks’ Distress Could Amplify the Global Sell-OffThe Chinese banking sector has been in focus because of rising concerns that the Chinese economy – the second largest in the world – will suffer a “hard landing”. The market first became especially focused on this risk in August, triggering a ~14% correction in the global financials index. Although much of this decline was recovered in the fall, sharp declines to start 2016 demonstrate that the risk remains at the top of investors’ minds, in part because of concerns that Chinese government statistics are unreliable, and are perhaps obscuring signs of a material slowdown, if not distress.

In a three part series, we will review the macro risk of the Chinese banking sector. In the first two parts, we make the assumption that the data is unreliable and that there are, in fact, challenges in China and, by extension, its banks. In this note, we take the perspective of the bears, and provide four reasons why the risk of distress in the banking sector could trigger a further correction in the global markets. In Part #2, we take the perspective of the bulls, and provide arguments why macro risk posed by Chinese banks is overstated. In Part #3, we provide a review of the solvency of the sector using reported data.

Without a doubt, there are highly credible arguments supporting the thesis that Chinese banks will – at some point – be a source of some form of macro uncertainty, and possibly a more severe market correction. In fact, calling the health of the Chinese banks into question is significantly easier than defending it, since the arguments are simpler to make. Below we address what we believe to be the most important reasons supporting the conclusion by the bears that the sector poses a significant threat to the global markets.

Reason #1: Enormous Size of Banks Relative to Economy + Deteriorating Credit is OminousThe sheer size of the sector relative to the size of the Chinese economy is a potentially large red flag. Total assets of the Chinese banks are ~2.5x larger than the country’s GDP, making China a global outlier (note the United States is at less than 1.0x of GDP).

This concern is amplified by the fact that the sector is primarily domestically focused, i.e., Chinese banks are not large because of significant assets outside of China, unlike, say Swiss banks, which are global banks located in a small country (or even the Canadian banks, which have large assets outside Canada). In fact, four of the five largest banks in the world are from China and have combined assets of ~US$11 trillion in assets[1].

The huge size of the sector relative to its economy creates concerns that the Chinese banks are “too big to save” by the government should significant asset problems arise.

Reason #2: Government Control/Influence on a Banking System Usually Equals Credit ProblemsHistory has shown that in countries where there is significant government control (or even excessive influence) over the banking sector, widespread misallocation of capital, and inevitably, credit problems within its banking system[2]result. Therefore, the simple fact that China exerts ownership/control over its banks – both public and private – would suggest a high risk of significant credit losses emerging within the Chinese banking sector, even if they are not evident at the moment.

Reason #3: Actual Contagion is Not Necessary to Precipitate a Global Sell-offIf the market believes that a macro event is possible, bank investors first assess the direct effect on those countries/companies immediately impacted. Investors then shift their focus to the second derivative effects, i.e., “could contagion from this event precipitate a material decline in GDP growth, either globally or in a(nother) region to which the sector is exposed?”

To illustrate, both the Asian crisis in the late 1990’s and the recent European sovereign debt crisis triggered material corrections in the Canadian banks, as the market became concerned about these crises’ influence on global growth and other potential contagion. In fact, during the Asian Crisis, the Canadian banks declined ~35% in just three months, and took approximately two years to recover. In the European sovereign debt crisis, the sector declined ~17%, and took ~9 months to recover (but it is possible that this could have been more severe had it not been for aggressive policy action by the other eurozone countries[3]).

Reason #4: Monoline Structure of Largest Banks Adds to System’s Risk ProfileHistory has shown time and time again that insolvency or risk of financial distress arises when banks have too much of “something”, whether it is exposure to a geography, a business, or an individual sector/credit. As a result, banks with greater diversification by revenue, products, and geography fare better in downturns.

When China modernized its banking system in 1978, it opted to arrange it by creating essentially monoline lenders, namely Agriculture Bank of China (ABC – rural banking), China Construction Bank (CCB – construction industry), and Bank of China (BOC – foreign currency transactions and international business). A few years later, it established the Industrial and Commercial Bank of China (ICBC – industrial and commercial banking activities). By creating specialty monoline lenders – we presume to ensure more accurate allocation of capital by the banks – policy makers introduced concentration, thereby adding to the financial risk of the individual banks.

The most vulnerable loan category in an economic slowdown is almost always construction lending, and as mentioned, China has one giant bank focused almost exclusively on this type of loans; China Construction Bank, with total assets approaching a staggering ~US$3.0 trillion, is the second largest bank in the world. If China suffers from a major credit bubble bursting, then a massive systemically important construction bank would have the potential to be the epicentre of this macro risk.

Conclusion: To Trigger Global Sell-off, Market Repricing of Risk Does Not Need LinkageThe bears would argue that China and its banks contain the essential ingredients of systemic risk, which, combined with a credit bubble, will inevitably end badly. Put differently, these characteristics will overwhelm the reported data, either because it was deliberately misstated, and/or because an abrupt decline in GDP results in rapid deterioration. Therefore, there are reasons to believe that should China experience a hard landing and/or see its banking sector experience distress, it could amplify or trigger a(nother) global sell-off.

(1) Sources for this three part series are SNL Financial LC and Hamilton Capital. The universe of companies consists of 20 major publicly traded Chinese banks, or ~70% of total bank assets in China, all of which the government holds a controlling interest (total assets of ~$17.5 trillion at YE). Our universe does not include the three wholly government owned “policy banks” (i.e. Agriculture Development Bank of China, China Development Bank, and the Export-Import Bank of China) which account for a further ~10% of the total Chinese banking system assets (i.e. an additional ~US$2.5 trillion at YE).

(2) With respect to China, foreign investors can generally invest in only the ‘H’ shares (13 of the 20 public banks in our universe), while domestic investors can also invest in the ‘A’ shares (7 additional banks).

(3) There is not sufficient and/or reliable information to review the implications of Chinese “shadow banking” system (including Chinese wealth management products), to the extent it exists.

Notes

[1] In addition, there are many large banks in China outside of the top five that are less well known to investors, but are nevertheless very large. For example, Bank of Communications (3328-HKG) and Postal Savings Bank of China, both have total assets in excess of US$1 trillion. There are also three “policy” banks, which are wholly owned by the Chinese government, and have total assets of ~$2.5 trillion.[2] It is also a recipe for low absolute GDP per capita; there is a clear correlation between countries with free market banking systems and higher GDP, which is why trends in financial regulation are important to monitor.[3] This policy action was carried out, most importantly, through the European Financial Stability Fund (EFSF), which was effectively a de facto nationalization of GIIPS country debt to the broader eurozone.

Hamilton Capital Partners

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